What Are Exchange Traded Funds?
Exchange Traded Funds (ETFs) are baskets of investments such as stocks, bonds, commodities, currencies, options, swaps, futures contracts and other derivative instruments that are created to mimic the performance of an underlying index or sector.
ETFs are often compared to mutual funds because they pool investors’ assets and use professional fund managers to invest the money according to a specific strategy detailed in the fund’s prospectus.
How Are Exchange Traded Funds Bought And Sold?
Unlike a mutual fund, which is bought or sold directly from the fund issuer at the fund’s net asset value (NAV), which is set at the end of each trading day, an ETF is bought and sold on an exchange like any other listed stock at a price continuously determined on the exchange.
Common Types Of ETFs
- Index – Seeks to mirror the performance of a specific investment index, such as the S&P 500 or the Dow Jones Industrial Average.
- Commodity – Seeks to mirror the performance of a specific commodity or commodity group, such as gold or oil.
- Bond – Seeks to mirror the performance of a specific bond index or product, such as U.S. Treasury or municipal bonds.
- Currency – Seeks to mirror the performance of a specific currency or basket of U.S. or international currencies, such as the Euro or Yen.
- Industry – Seeks to mirror the performance of a specific industry segment, such as healthcare or manufacturing.
What Are The Risks Associated With ETFs?
- Liquidation – Liquidation of ETFs often include the charging of termination fees and can result in lost opportunity costs if the providers convince investors to stay in the fund through the liquidation process to save on commission costs. Commission savings are often not worth the additional risk of staying in a liquidating fund.
- Tax consequences – While traditional ETFs may provide greater tax efficiency through fewer capital gains distributions, non-traditional ETFs may be less tax efficient due to daily resets that promote more frequent trading, which can result in significant short-term capital gains that may not be offset by a loss.
- Redemption – For most retail investors, the only option for redeeming shares of an ETF is to sell them through a broker on the secondary market. By comparison, mutual funds may be sold back to the fund’s issuer for the fund’s cash equivalency.
- Fees – Traditional ETFs charge a management fee that is deducted directly from the assets of the fund. The fee, called an expense ratio, management fee or investor fee, typically ranges from 0.1 percent to 1 percent. Because ETFs trade like stocks, brokerage commissions and transaction costs typically apply to ETF purchases and sales on a per transaction basis. Leveraged and inverse ETFs must be traded more frequently because of their volatility, therefore incurring substantial brokerage fees and commissions.
Before You Invest In An ETF
Just like other investment opportunities, you should contact the Washington State Department of Financial Institutions (DFI) to determine if the ETF and the person recommending the investment are properly registered in Washington. Contact DFI at 1.877.RING DFI (746-4334).
ETFs should be registered with the U.S. Securities and Exchange Commission (SEC). You should ask for and read the ETF’s prospectus before investing.